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Can Consumer Staples Rebound?

The dismal run of Consumer Staples continued in the first three months of 2014, after lackluster performances in 2013 and 2012. Continued pressure of a difficult consumer spending environment, foreign exchange headwinds and declining volumes were cited as the main reasons for this weakness.

Middle-class consumers struggled to cope with rising gas prices, delayed income tax refunds and higher payroll taxes. In addition, difficult operating conditions in Europe and a slowdown in some Asian countries, like China, also weighed on the sector’s outlook. Consumer staple stocks have also underperformed the S&P 500 as a whole in the past year.

Unlike discretionary items, demand for consumer staples remains relatively stable across the economic cycle. This perceived safety of the group’s business outlook is a major reason why consumer staple stocks tend to become more in demand in times of uncertainty.

Consumer staple stocks are certainly not the only safe or defensive stocks, but they do benefit from heightened perception of risk in the marketplace. This is the reason why consumer staple stocks have done reasonably well year to date, with the average price of consumer staple stocks in the S&P 500 up +7.8% vs. a gain of +6.7% for the index as a whole in that time period.

But consumer staple companies are witnessing sluggish growth in the developed markets due to market saturation, which along with stagnant disposable incomes and increased competitive activities have added to the companies’ woes. This is the reason why companies have been looking to faster growing emerging markets. That’s a good strategy in the long run, but the near-term outlook for many of these markets remains uncertain.

The policy environment has changed rapidly from pricing and import controls in some emerging countries to political unrest in others that has temporally disrupted business operations. The ongoing currency fluctuations are also problematic, as a stronger dollar reduces the value of outside-U.S. sales and in turn limits growth. In fact, the market growth rate of developing countries slowed down in the last reported quarter.

Lackluster top-line growth, lower volumes as well as currency headwinds have been a drag on the results of consumer staples companies in the first half of 2014 and have led many of them to provide a weak outlook for 2014. In such a scenario, some of these companies managed to increase their earnings solely with the help of cost controls, inorganic growth and share buybacks, which signals a lack of real growth.

Let us look into the initiatives undertaken by the companies to bolster their earnings in an uncertain and volatile macro environment.

Innovations

In a crowded and competitive space, consumer product companies need to regularly innovate and upgrade their brands to create differentiated value propositions for their customers and to remain successful.

In May, beverage giant PepsiCo, Inc. (PEP - Free Report) unveiled its new digital soda dispenser, Spire, which will allow customers to make up to 1,000 personalized carbonated beverages by selecting their favorite Pepsi brands. Spire is expected to directly compete with The Coca-Cola Company’s (KO) Freestyle fountain machines, available since 2009.

Kimberly-Clark also expects to make further progress by expanding the adult care products and baby wipes internationally. It also has an innovative pipeline in North America that includes Huggies diapers and baby wipes, GoodNites youth pants, Depend briefs and Viva towels.

Shifting Focus on Health and Wellness and ‘Good-for-You’ Products

The companies are shifting focus to make healthier and nutritious products in view of increasing health consciousness, rising obesity concerns and growing regulatory pressures.

Beverage companies like Coca-Cola and PepsiCo are expanding their portfolio of non-carbonated drinks due to the increasing awareness about calorie intake and nutrition among consumers and declining demand for carbonated beverages. While Pepsi plans to launch lower calorie, naturally sweetened non-cola products in the U.S. this year, Coca-Cola launched Coca-Cola Life, a naturally sweetened mid-calorie cola in Chile and Argentina in 2013. In 2014, the company plans to expand Coca-Cola Life to other markets.

Another beverage company Dr Pepper Snapple Group Inc. (DPS) has launched many low-calorie versions of its popular brands like Dr Pepper, 7UP, Sunkist Orange Soda, A&W Root Beer, Canada Dry Ginger Ale and RC Cola. Further, it is planning to test market for low-calorie version of Snapple straight up tea and naturally-sweetened, 60-calorie versions of some of its CSD brands (Dr Pepper, 7UP, and Canada Dry). Coca-Cola’s bottler Coca-Cola Enterprises Inc. (CCE) is also slowly shifting its product mix from colas to energy drinks and other non-carbonated beverages.

Food company B&G Foods, Inc. (BGS) and cereal maker General Mills Inc (GIS) also plan to roll out more nutritious products in 2014.

Food and beverage companies are not the only ones trying to shift to healthier options. Tobacco companies are also adapting to the evolving needs of consumers and have resorted to less harmful alternatives like electronic cigarettes (e-cigarettes).

In the electronic cigarette industry, cigarette maker Lorillard Inc (LO) owns a leading position in the U.S. after it acquired e-cigarette brand blu e-Cigs in Apr 2012. Later, with the acquisition of U.K.’s e-cigarette brand SKYCIG on Oct 3, the company further strengthened its position in the market. Nu Mark, a subsidiary of Altria Group Inc (MO - Free Report) , launched its e-cigarette brand -- MarkTen in Aug 2013. Moreover, the recent acquisition of the e-vapor business of Green Smoke Inc. in Apr 2014 enhanced its competitive position in the market.

Reynolds American Inc’s (RAI) Vuse e-cigarette brand also received favorable response since its launch in 500 stores in Colorado in Jul 2013 and has gained significant market share. In May 2014, Reynolds announced that it is making a multi-million dollar investment to expand the distribution of Vuse nationwide in fiscal 2014. Philip Morris International Inc (PM - Free Report) has plans to foray into the e-cigarette business in late 2015.

Cost Reduction and Restructuring Initiatives

Most consumer staples companies are divesting low-margin brands, improving supply chains and implementing cost-reduction initiatives in order to boost profits. These initiatives help companies to reduce the effects of inflating commodity costs and other input costs, which have remained a drag on margins of most companies in this sector.

Consumer giant Unilever NV (UN - Free Report) has been divesting its other businesses to concentrate on its core products such as detergents, foods, toiletries and specialty chemicals. Recently, the company sold its meat snacks business, the Royal pasta brand and its hair care brand. In November, it sold its Wish-Bone salad dressing business to Pinnacle Foods Inc (PF - Free Report) . It also sold its Skippy peanut butter business in Jan 2013 to meat producer Hormel Foods Corp. (HRL), while in Aug 2012, its Bertolli and P.F. Chang's frozen meals brands were bought by ConAgra Foods Inc. (CAG).

Kimberly-Clark also decided to spin off its healthcare business in Nov 2013 to optimize its performance and offer flexibility to pursue its own value-creation opportunities. It also divested its low-margin Huggies diapers business in 2012 in all the European markets, except Italy, to reallocate its resources to more promising markets.

Kimberly-Clark also has a cost savings program in place. Its FORCE (Focused on Reducing Costs Everywhere) targets to deliver at least $300 million of cost savings in 2014. Also, Kimberly-Clark anticipates operating profit to increase at least $100 million in 2014, owing to its pulp and tissue restructuring program, which was completed in 2012.

In May, snacking giant Mondelez International, Inc. (MDLZ - Free Report) announced a spin-off proposal for its coffee business to Netherlands-based coffee company, D.E Master Blenders 1753 in order to concentrate on its core snacks business. Also, the company announced a $3.5 billion, three-year restructuring program to accelerate cost savings and improve productivity. The program is expected to generate annualized savings of at least $1.5 billion by 2018, which can be re-invested for further margin expansion. The coffee deal will also allow the company to lower its supply chain and overhead costs.

Coca-Cola’s four-year productivity and reinvestment program, started in Feb 2012, is expected to generate incremental annualized savings of $550 to $600 million through 2015, while PepsiCo intends to generate $1 billion as productivity savings in 2014 under its current productivity plan. PepsiCo also announced a new 5-year restructuring plan last year that aims to generate annual productivity savings of $1 billion from 2015 to 2019. The savings are expected to come from improved efficiency through manufacturing automation and factory closures.

General Mills’ Holistic Margin Management (HMM) program has already delivered $1.4 billion in cost savings from 2010-2013 and is expected to generate additional productivity savings of $3 billion by 2020.

Expansion in Emerging Markets

Besides cost-saving initiatives, many consumer staples companies are shifting their focus to emerging markets to boost sales. Relative to the mature North American and European markets, emerging markets such as Brazil, India, China, Mexico, Russia and Southeast Asia are still untapped. Moreover, consumer spending in these markets is also increasing. The rising pool of middle class consumers in emerging markets represents a huge opportunity for these companies.

Tobacco company Philip Morris has a significant presence in a large number of markets. Asia remains a growth engine for the company as it enjoys robust growth in Indonesia, Pakistan, China, Philippines and Korea.

PepsiCo generates around 40% of its revenues outside the U.S. For the past few years, growth in developing and emerging markets has been higher than the developed markets and the trend is expected to continue for the next 5-10 years.

Cereal maker Kellogg Company (K) has tripled its emerging market business over the last decade. The Pringles acquisition in June 2012 consolidated its position in some of the fast-growing regions.

However, increased exposure to emerging markets also brings along currency headwinds, which adversely impacted the top line of several consumer staples companies like The Procter & Gamble Co. (PG), Unilever and Kimberly-Clark in the recently reported quarter. Though these companies expect currency headwinds to persist in 2014, they still forecast strong sales gains in the emerging markets.

Acquisitions and Strategic Partnerships

Many consumer staple companies are regularly carrying out acquisitions both domestically and internationally to expand their existing customer base and product lines into new markets. Some of them are also forming partnerships to take a lead in this challenging environment.

Meat companies Pilgrim’s Pride Corp. (PPC - Free Report) and Tyson Foods, Inc. (TSN - Free Report) have recently locked horns to win over packaged meat producer The Hillshire Brands Company (HSH). The purchase of Hillshire by either Pilgrim’s Pride or Tyson would make them the industry leader in chicken production and would increase their margins in other categories as well, such as desserts and lunch meats. The purchase would also benefit the winning bidder’s economy of scale with more customers and shelf space.

However, there is a holdup in the potential deal as Hillshire Brands is keen to buy Pinnacle Foods in order to strengthen its presence across the frozen, refrigerated and dry grocery categories. As of now, none of the deals have been approved but Hillshire has two alluring offers in the cards.

Likewise, cigarette maker Reynolds American is close to acquiring the third largest U.S. cigarette company, Lorillard, as per media reports on May 22. While a combination of these two tobacco giants will possibly create one of the strongest global tobacco companies, regulators could object to the deal to protect the U.S. tobacco industry from becoming a duopoly.

In Dec 2013, Altria had partnered with Philip Morris to combine their marketing powers to ramp up the distribution of their unconventional cigarettes. Altria and Philip Morris also decided to work together to gain market share as well as to improve the existing versions of the products.

In early Feb, 2014, Coca-Cola entered into a partnership with Keurig Green Mountain, Inc. (GMCR) in which the latter will exclusively make Coca-Cola branded pods to be used on its upcoming Keurig Cold at-home beverage system for cold beverages. The deal opens up an exciting new packaging format for Coca-Cola brands.

In May 2014, Coca-Cola raised its stake in Keurig Green Mountain to 16% from 10%, as part of its 10-year partnership with Keurig to step into the world of cold beverages. This move makes Coca-Cola the largest shareholder of Keurig and will help the soft drink giant’s entry into the ‘single-serve at home’ format. For Keurig Green Mountain, this will be a great opportunity to leverage Coca Cola's branding and global presence.

Also in May, Keurig Green Mountain announced a distribution partnership with consumer food company The J. M. Smucker Company (SJM - Free Report) . The deal is an extension of an agreement signed in 2010 for marketing, manufacturing and selling of Smucker brands in Keurig Green Mountain’s K-cups.

In Dec 2013, food distributor Sysco Corp (SYY - Free Report) agreed to buy US Foods -- the second largest player in the foodservice distribution industry -- to create one of the largest food companies in the country. The merger will give Sysco increased size and scale in this low-margin business and will also provide significant cost savings opportunities.

Zacks Industry Rank

Consumer Staples is one the 16 broad Zacks sectors within the Zacks Industry classification. We rank all the 260 plus industries in the 16 Zacks sectors based on the earnings outlook and fundamental strength of the constituent companies in each industry. To learn more visit: About Zacks Industry Rank. https://www.zacks.com/zrank/about-zacks-industry-rank.php

As a guideline, the outlook for industries in the top 1/3rd of all Industry Ranks or a Zacks Industry Rank of #88 and lower is 'Positive,' the middle 1/3rd or industries with Zacks Industry Rank between #89 and #176 is 'Neutral' and the bottom 1/3rd or Zacks Industry Rank of #177 and higher is 'Negative.'

The Food – Meat Products industry is the best placed with a Zacks Industry Rank #4, which places it in the top 1/3rd of the 260+ industry groups. It is followed by Consumer Products – Miscellaneous Staples and Publishing – Newspapers with Zacks Industry Ranks of #55 and #79, respectively.

Industry groups like Soaps & Cleaning Preparations and Tobacco lie in the middle 1/3rd sharing a common Zacks Industry Rank #109. Textile – Apparel and Beverages – Soft are also placed in the middle 1/3rd.

The rest of the sub-sectors, Food – Miscellaneous/Diversified, Cosmetics & Toiletries and Beverages – Alcohol are featured in the bottom one-third with respective Zacks Industry Ranks of #182, #195 and #212.

Looking at the exact position of these industries, one could say that the general outlook for the consumer staples space as a whole is neutral, as most of the companies suffered as a result of an uncertain macroeconomic environment in the first quarter of 2014. Though the companies have provided a soft outlook for 2014, they are hopeful that it will start recovering through 2015.

Earnings Trends

Earnings continued to be weak in the consumer staples sector in the first quarter of 2014 due to sluggish top-line growth, foreign currency headwinds and slowdown in the developing markets. We believe that the first quarter 2014 results remained soft in terms of earnings beat ratios (percentage of companies coming out with positive surprises) and revenue.

For the 94.1% companies in the consumer staples, which have already reported, the earnings "beat ratio" was 56.3%, while the revenue "beat ratio" was only 31.3%. Total earnings for this sector increased 2.2% in the reported quarter compared with growth of 3.5% registered in the fourth quarter. Total revenue declined 0.1% in the quarter as against growth of 1.2% in the previous quarter.

This signals a difficult consumer spending environment for the rest of 2014, which is also reflected in the weak guidance provided by the companies.

Per the consensus, earnings are projected to grow 5.1% in 2014, lower than 5.8% growth expected earlier. Revenues are expected to decline 6.5%, more than the prior estimate of a 6.0% decline in 2014.

The consumer staples sector is expected to account for 6.7% share of the S&P 500 index earnings in 2014 compared with 6.5% in 2013. It accounts for 7.7% of the total market capitalization in 2014 so far compared with 7.2% in 2013.

OPPORTUNITIES

Despite macroeconomic headwinds, some of these companies have been able to deliver impressive results and have the potential to grow in the upcoming quarters.

Beverage company Constellation Brands Inc. (STZ - Free Report) has a solid brand portfolio enhanced by regular acquisitions and innovations, impressive wine volume growth and effective cost management. Dr. Pepper Snapple, though suffering from weak volume trends due to ongoing pressure in the U.S. carbonated soft drinks (CSD) category, has delivered improved earnings results from the last two quarters with strong margins. The company also has an efficient cost management program and regularly returns cash to shareholders. Both Constellation Brands and Dr. Pepper Snapple hold a Zacks Rank #2 (Buy).

Tyson Foods, despite holding a Zacks Rank #3 (Hold), expects 3% to 4% top-line growth annually, backed by strong focus on its value-added chicken products, prepared foods and beef and pork segments. Tyson also expects demand for protein to go up in the near future.

Natural and organic food/beverages maker The WhiteWave Foods Company (WWAV) has been benefiting from continued robust volume growth of plant-based almond beverages and non-dairy yogurts and growth in soy beverages. This Zacks Rank #1 company has also raised its forecast for 2014 as it expects to gain from the natural/organic food revolution.

WEAKNESSES

There were some companies hit hard by the challenging macro-economic environment, owing to lower consumer spending. In Europe, though signs of improvement are visible, the economic conditions are still challenging.

Zacks Rank #3 companies like Procter & Gamble, Mondelez International and Kellogg are facing the brunt of sluggish sales, currency headwinds, slower developing market growth and poor volumes. U.S. fruit firm Chiquita Brands International Inc. (CQB), with a Zacks Rank #5 (Strong Sell) has been struggling with the supply and pricing of its raw products, while UK-based brewer Diageo Plc (DEO), holding a Zacks Rank #4 (Sell) expects weak consumer demand and declining sales to pressurize its performance in the rest of the year.

Though these companies are fundamentally strong and regularly innovate products, invest in the emerging markets, adopt cost savings and restructuring measures to revive margins, we are uncertain about the economic environment in 2014, primarily due to constricted consumer spending. However, we do believe that the scenario will improve soon.

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